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Taxing Damages for Emotional Distress

he Court of Appeals for the District of Columbia on
Dec. 22, 2006, vacated its judgment from four months earlier in
Murphy, Marrita v. IRS in which the court held
that a lawsuit award for emotional distress was not taxable. The
government had petitioned for an en banc hearing. Instead, a panel
indicated it will rehear the case, with oral arguments set for April
23.

The Internal Revenue Code imposes tax on all income regardless of
its source, unless the income is specifically excluded. One such
exclusion provided by IRC section 104(a)(2) is for damages received on
account of physical injuries. Since not specifically excluded by
section 104, damages that do not relate to physical injuries, such as
those paid for emotional distress, typically are included in a
taxpayer’s income and are subject to tax.

Marrita Murphy challenged the constitutionality of taxing damages
for nonphysical injuries. Murphy worked for the New York Air National
Guard (NYANG). When she complained to state authorities that a NYANG
airbase contained environmental hazards, NYANG retaliated by
blacklisting her and giving poor recommendations to potential new
employers. Because these acts were violations of the whistle-blower
statutes, NYANG was ordered to pay the taxpayer damages in the amount
of $70,000: $45,000 on account of her emotional distress or mental
anguish and $25,000 for the injury to her professional reputation.

Murphy originally included the full amount of the damages in her
gross income and paid the appropriate taxes, but she later filed an
amended return claiming a refund based on the exclusion in section
104(a)(2) regarding damages received “on account of personal physical
injuries or physical sickness.” After the IRS denied the claim, she
filed a lawsuit in district court.

The taxpayer first argued that the damages she received should be
excluded under section 104 because she suffered from physical
manifestations of her emotional injury. In the alternative, Murphy
argued that damages paid with regard to nonphysical injuries are not
“income” as the term has been defined by the U.S. Supreme Court. The
district court ruled for the IRS, and Murphy appealed to the Court of
Appeals for the District of Columbia.

Result. For the taxpayer initially, although
the D.C. Circuit vacated the judgment and will rehear the case. The
Internal Revenue Code was amended in 1996 to provide that emotional
distress is not treated as a physical injury or physical sickness for
purposes of section 104; as a result all damages other than those for
physical injury fall within the general inclusion rule of section 61.

Murphy submitted evidence that as a result of NYANG’s conduct she
suffered from bruxism, a stress-related condition that caused her to
grind her teeth, resulting in permanent damage to her teeth. However,
the D.C. Circuit found that although she suffered from physical
injuries, the damages she received were not awarded on account of such
injuries, and therefore section 104 was not applicable.

Murphy alternatively argued that the damages were not income within
the 16th Amendment, and therefore could not be subject to tax. The
Supreme Court defined income in 1955 in Glenshaw Glass as
gains and “accessions to wealth,” and it has long been recognized that
a return of capital falls outside this definition of income. Murphy
argued that the damages she received, which compensated her for the
loss of her emotional well-being and reputation, were a return of
human capital and therefore not income. She contended that the Supreme
Court alluded to the notion of human capital in Glenshaw Glass,
where it distinguished taxable punitive damages from damages for
personal injury; the latter, it held, are compensatory in nature and
therefore not taxable income. Since Glenshaw Glass did not
differentiate between physical and nonphysical damages, Murphy argued,
the Supreme Court intended that all damages for personal injury be
excluded from income.

The IRS’s rebuttal to this argument distinguished human capital from
financial capital. Financial capital has a basis, such that when it is
sold there is income to the extent that the amount realized exceeds
the taxpayer’s basis. The IRS argued that since people don’t pay for
their reputation or emotional well-being, there is no basis and
therefore the entire amount received constitutes income.

The D.C. Circuit used an “in lieu of” analysis and held that the
damages were not income. If a taxpayer receives damages in lieu of
something that is normally subject to tax, such as wages, then the
damages would be taxed. However, the taxpayer’s emotional well-being
and reputation were not taxable, and therefore neither are the damages
she received as a result of her losses. In addition, based on a review
of the legislation that implemented Congress’ taxing power provided in
the 16th Amendment, particularly the original exclusion for personal
injury damages, the court found that the framers of the 16th Amendment
would not have construed compensatory damages for nonphysical injuries
to be income. Accordingly, the court held that the taxpayer’s damages
for emotional distress and loss of reputation did not constitute
income within the Constitution and the IRC, and any application of
section 104(a)(2) that subjects such payments to taxation is
unconstitutional.

TAX NEWS

President Barack Obama signed legislation that retroactively extended more than 50 expired tax provisions for 2014, allowing taxpayers to take advantage of a host of tax incentives during this filing season.

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